On October 1, 2011, the mortgage markets in some parts of the U.S. may suddenly slow. At that time, the conforming loan limits -- the highest balance permitted on a mortgage backed by the U.S. government -- will be cut for "high cost areas." So if you want to buy a home in a place like Los Angeles, Manhattan, or D.C., where real estate is relatively expensive, it may be more difficult to get a cheap mortgage stamped with a federal guarantee. Will this change debilitate the housing markets in these areas?

How Conforming Limits Work

First, what will this change entail? Conforming limits are kind of complicated, because they vary county-by-county.

The Current Formula

The loan limit right now, and through September 30, 2011, is calculated by taking the median home price in 2007 and multiplying it by 125%. The maximum loan amount the government can insure is either that value or $729,750, whichever is lower.

Let's take San Francisco, CA, for example. According to the National Association of Realtors, in 2007, the median home price was $804,800. If you multiply that by 125%, you get a little over $1 million. But since that's more than $729,750, the conforming loan limit is only $729,750.

It should be noted, however, that the Federal Housing Finance Agency uses its own median home price estimates. I'm using the NAR data for explanatory purposes. Also, Alaska, Hawaii, the U.S. Virgin Islands, and Guam have different calculation methods and should be ignored in this analysis.

The New Formula

As of October 1st, these loan limits will decline. The new loan limit is calculated by taking the median home price in 2010 and multiplying it by 115%. The maximum loan amount the government can insure is either that value or $625,500, whichever is lower.

Let's consider San Francisco again. According to NAR, in 2010, the median home price was $567,900. If you multiply that by 115%, you get $653,085. But since that's more than $625,500, the conforming loan limit is only $625,500.

Get it? If you're curious on the full list of conforming loan limits after October 1st, it can be found here (in Excel spreadsheet format), on the FHFA website.

The $729,750 Question

During a recent hearing on the housing market, a few Congressmen from California were complaining about this October 1st reset. They fear that it will harm the housing markets in their districts, where homes often cost well above $625,500. As a result, you shouldn't be surprised to see some legislation offered later this year that would try to extend the timeline for the old limits. But is this necessary? There are two ways to look at this.

Let the Old Limits Expire

It could easily be argued that these loan limits ought to expire. Think about how they were calculated to begin with. They were based on 2007 home prices, which were much higher in most of these high cost areas than they are today. In the example above, you can see the median price declined in San Francisco by about $237,000 or 29%. But the loan limit the region faces will only decline by $104,250 or 14%. So really, the new standard is more generous than it was when it was first established in 2008 for areas that have seen big price drops. These areas that saw big price declines, where the housing market is probably the most fragile, are those that would need government support the most.

Extend the Old Limits

Of course, the mortgage market has adjusted to the old limits, which have been in place for the past three years. In these high-cost areas, more mortgages will now have to utilize purely private financing, as they will not qualify for government support. Where does that financing come from? Banks could take on this risk. The securitization market might also finally begin providing mortgage-backed securities again for these jumbo mortgages. The problem is that residential mortgage securitization remains weak, so it isn't a reliable source of funding at this time.

At some point, these high-cost areas will have to be weaned off government support to some extent. In fact, the Treasury has said that it plans to begin reducing conforming limits across-the-board in coming years. The question here is really one of timing. Is the financial industry ready to take on more mortgage risk than it has over the past three years? If it isn't, then the housing markets in some of the hardest-hit areas may have even more trouble recovering when conforming loan limits decline. Will things get worse if the government begins to slowly back away?

About the Author

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation.

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